“C’mon, Janet – Raise that rate, big league!”
One can imagine President Donald Trump at least thought about tweeting that the night before the U.S. Federal Reserve raised its benchmark interest rate by 0.25%.
Frankly, we were somewhat surprised at Trump’s silence on this matter given his frequent criticisms of Fed Chair Janet Yellen over the last year. But tweets or no tweets, the bond market’s reaction to the third interest rate hike in 10 years shows that the market has already discounted the likelihood of further interest rate hikes for the rest of the year.
But in the meantime, the outlook for continued strength in the U.S. dollar has many investors questioning what that will mean for their foreign equity assets.
This is a fair question, and one that is worth taking some time to think through.
For U.S. dollar investors, a strengthening dollar does have the immediate effect of reducing the dollar price of non-dollar securities – including equity securities. But an equity security is more than a piece of paper. It represents a share of ownership in a company and a stake in that company’s present and future earnings. But how will a rising dollar impact those earnings?
For companies that sell goods and/or services in the United States but are headquartered overseas, the initial earnings effect is positive. Strong dollar revenues are translated into weaker domicile currencies. This results in higher domicile currency earnings than would otherwise be the case. In a nutshell, as the dollar rises, so do reported earnings. But that’s just accounting.
How a Strong Dollar Impacts a Non-U.S. Company’s Operating Costs
What’s even more interesting is the effect that currency rates can have on a company’s competitiveness. A company that pays its operating costs in a weaker currency than that of its competitors is in an advantaged position. It enjoys lower operating costs than competitors, which will widen margins and result in higher profits.
It also has additional pricing flexibility. Thanks to a weaker operating currency, this company has the option of lowering prices without suffering from narrower margins. Rather than taking on higher margins, it can decide to keep stable margins while trying to increase market share. Or the company may take the opportunity to look further into the future and use its increased financial flexibility to improve its market position and widen its defensive moat.
Examples – depending on the industry – could range from expanding an after-sales service network to increasing research and product development efforts.
The point here is that a stronger dollar, should it persist, will have an effect on companies around the world. For companies that are domiciled overseas – particularly those that compete with U.S. companies – that effect is potentially quite positive in terms of profitability and competitiveness.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks.